A Distributed Profits Tax in Poland

Key Findings

• The Polish government has considered replacing its traditional corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. with a distributed profits taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. (DPT).
• Poland’s current corporate tax system distorts investment by reducing the level of investment, the distorting the type of investment, and its form of financing.
• Based on original economic modeling, the reform would reduce marginal effective tax rates on new investment, reduce distortions across types of assets and forms of financing, and, as a result, boost investment, wages, and economic output. Full implementation would increase long-run GDP by 2.3 percent, investment by 3.3 percent, and wages by 2.0 percent.
• The reform would be especially important for risky investments, or those that do not immediately pay off for investors. Under current law, the Polish system penalizes this form of investment much more than most other countries in the Organisation for Economic Co-operation and Development (OECD).
• We estimate that the distributed profits tax would reduce corporate tax revenue by PLN 36.7 billion per year, or 1.6 percent of GDP. However, total Polish revenue would decline by less than that, PLN 24.8 billion per year, in the long run after considering the economic impact of the reform.

Background

Poland is one of the strongest-growing economies in Europe and aims to maintain this trajectory despite current challenges, including trade disruptions, geopolitical uncertainties, and the country’s ambitions to expand its defensive capabilities.

To encourage investment and economic growth, the government has been exploring options to reform the corporate income tax. Corporate tax reform can be an important factor in continued investment and growth. According to the OECD, the corporate income tax can be the most harmful to growth because it burdens capital investment—primarily driven by corporations.[1] Furthermore, the corporate income tax can have a direct impact on living standards. Empirical research finds that more than half of the corporate tax burden is borne by workers in the long run, as reduced investment leads to a smaller productive capital stock, lower labor productivity, and, thus, lower wages over time.[2][3]

One promising reform to the corporate tax would be to replace Poland’s traditional corporate income tax with a distributed profits tax. In contrast to a traditional corporate income tax, it would only apply to profits upon distribution. As a result, profits retained for investment would remain tax-free. Any distributions, regardless of form, would face the same statutory tax rate. Poland has already introduced a pilot distributed profits tax called the “Estonian CIT.”

This study examines the current legal framework and the potential impacts of fully adopting a distributed profits tax. Using a macroeconomic model, we simulate the effects of adopting a distributed profits tax in Poland on long-run GDP, investment, and wages, employing a cost-of-capital approach that considers changes in capital allowances and the treatment of debt and equity financing. Further, there are benefits to the reform that go beyond the modeling exercise. Notably, it would greatly improve Poland’s tax treatment of “risky” investment, or those that do not have an immediate payoff, a marked shift from its current restrictive policy.

Current Law

Under current law, Poland has a traditional corporate income tax for all companies and an optional distributed profits tax for small enterprises. Poland’s corporate income tax system ranks 12^th on the International Tax Competitiveness Index, mostly due to its low headline corporate tax rate of 19 percent. However, the corporate tax system only ranks 36^th out of 38 countries in terms of complexity and the presence of selective incentives.[4] Further, Poland’s capital allowances rank 33^rd out of 38 OECD countries and second-to-last in the European Union, allowing firms to deduct less than 60 percent of their capital investment from taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. when weighted over a representative capital stock.[5] Similarly, Poland’s tax treatment of losses ranks among the three most restrictive systems in the developed world.

Corporate Rates

Poland’s corporate tax rate stands at 19 percent, below the OECD average of 23.9 percent. Only three OECD countries—Hungary (9 percent), Ireland (12.5 percent), and Lithuania (15 percent)—have lower headline corporate tax rates. In addition to the standard rate, there is a 9 percent small business rate and an innovation box scheme that reduces the tax rate to 5 percent on qualified income derived from intellectual property (IP) rights.

Small businesses can qualify for the 9 percent rate if they are in their first year of business or if their revenue in the previous fiscal year was under EUR 2 million. This threshold creates a significant tax cliff: once a business crosses the EUR 2 million revenue mark, its statutory tax rate more than doubles. The abrupt increase can discourage growth by incentivizing businesses to limit their activity or even underreport earnings to remain below the threshold. [6] Additionally, it creates barriers to mergers and acquisitions, which could otherwise generate economies of scale and productivity gains.

The innovation box scheme reduces the tax rate applicable to income derived from IP rights. Although this provision is meant to encourage the creation of high-return assets, it can discourage investment in some cases.[7] It can also encourage tax avoidance. Since the source of income within a company is hard to classify, the preferential treatment creates incentives to engage in tax planning by assigning income to intangible assets.[8]

Capital Allowances

Under a traditional corporate income tax, investments in capital assets (e.g., machinery, structures, and intellectual property) are deducted in line with prescribed schedules. These schedules often attempt to align deductions with the decline in the value of a given asset but often vary significantly from this ideal. Furthermore, disallowing a full, immediate deduction for investment expenses brings a portion of the asset’s returns into the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , reducing the incentive to invest.[9]

The Polish depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. system has 37 separate investment classes that fall into three major categories: plant and equipment, structures, and intellectual property products. The value of capital allowances varies by major asset type. The net present value of capital allowances for structures, which tend to have longer asset lives, ranges from 22.7 percent for dwellings (rental properties) to 53.7 percent for structures such as bridges, tunnels, dams, or car parks. Capital allowances for machinery, equipment, and weaponry have a net present value of 83 percent and cultivated biological resources have a net present value of 65.1 percent.

The treatment of intangible assets varies by type of asset. Research and development, which qualifies for a super deduction, receives a deduction equal to 200 percent of the asset’s original cost. Other intangibles have a net present value of 93.6 percent.

Land and inventory do not receive depreciation deductions. Rather, both assets are only deducted when sold. Poland allows businesses to use the last-in, first-out (LIFO) method for determining the cost of inventories sold.[10]

Table 1. Overview of Treatment of Different Investments in Poland

Note: Capital allowances are discounted at a real discount rate of 5 percent and an inflation rate of 2 percent.
Source: Authors’ calculations.

Polish capital allowances are some of the least generous in the OECD. The weighted average across non-land and inventory assets is 59.3 percent compared to the OECD average of 68.6 percent. Within Europe, only Hungary has less generous allowances at 58.3 percent.

Figure 1.

Treatment of Financing

Consistent with traditional corporate income tax systems, Poland’s corporate tax allows for a deduction for interest expense on debt-financed investments. This deduction, however, is limited for any interest expense that exceeds 30 percent of a firm’s earnings before interest, tax, depreciation, and amortization (EBITDA), as prescribed by the EU Anti-Tax Avoidance Directive (ATAD).[11] Across the OECD, all countries except Israel apply some form of interest deduction limit, with 30 out of 38 countries applying similar earnings-based limits.

Under the ATAD, EU Member States are permitted to grant businesses the ability to deduct interest in excess of the prescribed threshold under certain circumstances. In line with most other Member States, Poland allows businesses to carry forward unused interest deductions and has a de minimis threshold that allows EUR 3 million in net interest deductions per year to circumvent the interest limit. Poland’s rules also exclude interest expense from financial undertakings and loans for long-term public infrastructure projects, which is also consistent with rules in the majority of Member States. Poland is one of six Member States that do not allow for group escape clauses based on a debt-to-equity ceiling, a group EBITDA test, or exemptions to standalone companies.[12]

Under the traditional corporate income tax, the deductibility of net interest expense creates a bias in favor of debt-financed investment at the firm level. This is because equity financing is not similarly deductible. To address this bias, Poland introduced a notional interest deduction (NIT) in 2020, allowing businesses to deduct a deemed return to equity. However, the Polish NID is capped at an annual limit of PLN 250,000 (EUR 58,000), such that it limits the debt bias for small businesses but does not affect the marginal cost of capital and financing decisions for larger companies for which the cap is more likely to be binding.[13]

Loss Treatment

Many companies have investment projects with different risk profiles and operate in industries that fluctuate greatly with the business cycle. Carryover provisions help businesses “smooth” their income, making the tax code more neutral across investments and over time. Ideally, a tax code allows businesses to get a full, immediate refund for losses. But commonly, losses can only be carried forward to offset taxable income in future years or carried back to offset taxable income in previous years and receive a refund on taxes already paid.

Polish loss limitations are especially restrictive. Polish businesses can only deduct 50 percent of their losses against taxable income and can only carry forward losses for five years. Losses cannot be carried back to and deducted from past taxable income.[14] Poland’s tax treatment of losses is among the most restrictive in the OECD. Most OECD nations (22 of 38 countries) allow losses to be carried forward indefinitely, nine of which also place no limits on the amount of losses that can be deducted in the current year. Further, 11 countries also offer the option of loss carrybacks.[15]

Special Provisions

Since January 1, 2021, Poland has operated a pilot program for the distributed profits tax.[16] Under this program, taxpayers may opt, under certain conditions, to apply to be taxed under the Estonian CIT for a period of four years (with the possibility of extension). Firms that qualify are not taxed on annual profits. Instead, their profits are taxed only when distributed to shareholders.

From January 1, 2022, the restrictions have been loosened, broadening the number of corporate firms eligible for the scheme and abolishing the annual gross revenue ceiling of PLN 100 million (EUR 23 million) and minimum capital expenditure requirements.[17]

However, the Estonian CIT option remains limited by requirements on ownership structure, revenue composition, taxpayer establishment, duration of usage, and employment. Most importantly, it is limited to companies whose shareholders are natural persons and do not hold shares in other entities; they may also not receive more than 50 percent of their total income from passive income and related party transactions without economic added value, or be established during restructuring proceedings, e.g., as a result of merger or division. Firms can also not operate under the Estonian CIT for longer than four years, unless an extension is explicitly approved.[18] While more than 13,000 taxpayers already opted into the Estonian CIT pilot scheme, the program remains predominantly suited for small businesses due to these constraints.[19]

Investment Incentives Under Current Law

The incentive for a corporation to invest in a new project is driven by the cost of that investment. In the absence of taxation, the cost of an additional unit of investment, represented by the “service price of capital,” is equal to the sum of economic depreciation (the rate at which an asset declines in value) and the firm’s discount rate. The firm’s discount rate is equal to the return demanded by shareholders or lenders. Corporate taxes raise the cost of investment by increasing the pre-tax gross return required to cover taxes, economic depreciation, and returns demanded by shareholders.

Corporate taxation can distort investment decisions in several important ways. The corporate tax can distort the level of investment by making the overall cost of investment higher than it would otherwise be in the absence of taxation. A lower level of investment ultimately leads to a smaller capital stock and lower labor productivity, wages, and economic output.

Independent of the level of taxation, corporate taxation can also distort the type of investment by providing beneficial treatment for certain capital assets relative to others. This can reduce productivity by resulting in relatively more investment into one type of asset than what would occur in the absence of taxation. Although providing benefits for certain investments, such as research and development, can provide positive spillovers, these positive externalities are generally rare.

Finally, corporate taxation can also distort how businesses finance new investment. Generally, corporations can finance new investment with either debt or equity. Equity finance can take the form of either issuing new shares or using retained earnings. Traditionally, corporate taxation encourages debt-financed investment relative to equity by allowing an interest deduction. This distortion can result in higher levels of leverage in the corporate sector and increased macroeconomic instability.

The burden a tax code places on new investment is measured by what is called the “effective marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. ,” or EMTR. This tax rate measures the share of a pre-tax return required to cover taxes. For example, if a shareholder demands a return of 5 percent and the tax burden on new investment is 20 percent, the pre-tax return would be 6 percent. The EMTR would be 20 percent: (6% – 5%)/ 5%).

Under current law, the Polish corporate income tax places a positive tax burden on new investment. We estimate that the EMTR on new investment is 8.1 percent. However, EMTRs vary significantly by type of investment. Land (11.9 percent) and inventory (11.7 percent) face the highest EMTRs followed by plant and equipment (9.5 percent) and structures (8.2 percent). Intellectual property faces a negative 2.5 percent EMTR. This is due to the super deduction for research and development and the patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. .[20] The standard deviation across all assets is 3.4 percentage points.

The Polish corporate income tax also creates a meaningful bias in favor of debt-financed investment. The weighted EMTR on equity-financed investment is 15.6 percent, 25.3 percentage points higher than the EMTR on debt-financed investment of negative 9.8 percent.

Table 2. Poland’s Effective Marginal Tax Rates on Investment by Major Asset Classes, 2024

Note: The EMTR for equity-financed investment is a weighted average presuming a 10 percent distribution share.
Source: Authors' calculations.

Distributed Profits Tax Reform

The proposed reform would convert the corporate income tax into a distributed profits tax (DPT). A distributed profits tax is a business-level tax levied on companies when they distribute profits to shareholders, including through dividends and net share repurchases (stock buybacks). As long as a business retains its earnings, it faces no tax on those earnings.

This form of taxation was first introduced in Estonia in 2000 and subsequently in Georgia (2017) and Latvia (2018).[21] The existing literature estimates that the introduction of the DPT changed the capital structure of businesses from debt towards equity, especially retained earnings, and improved their liquidity.

Observing the capital structure for companies with similar characteristics between 1995 and 2004, Hazak (2009) estimates that the introduction of a DPT reduced the debt financing share by 6.5 percentage points while raising the retained earnings financing share by 4.7 percentage points. At the same time, companies had more liquidity, as indicated by an increase in the share of cash holdings in assets by 5.6 percentage points and a fall in overall liabilities to assets by 12.2 percentage points.[22]

Masso, Meriküll, and Vahter (2013) estimate the impact of adopting the DPT in Estonia on the Estonian economy relative to its Baltic neighbors between 1996 and 2003, using a difference-in-difference design.[23] Their results confirm the finding that the reform increased firm liquidity and a shift from debt to equity financing, raising the share of cash holdings in assets by 2.1 percentage points and the share of retained earnings by 11.1 percentage points, while reducing the debt financing share by 7.6 percentage points. Their point estimates increase over a longer period until 2008, with an effect of 15.2 percentage points on retained equity and negative 9.5 points on debt.[24] Further, they find positive effects on investment and labor productivity, estimating a 20.1 percentage point increase in the ratio of investment to capital and a 13.3 percent rise in labor productivity. Their findings hold for the longer sample until 2008.

Pikakken and Vaino (2018) find similar effects when using a longer time horizon, up until 2016, and test for a broader control group beyond Baltic states, including Finland, Slovakia, and Poland. Their results indicate that the reform lowered the debt financing share of Estonian companies by 1 to 5 percentage points, but total liabilities by 11.5 percentage points. The share of investment financed by retained earnings increased by 7.3 to 8.8 percentage points and cash holdings increased by 1 to 1.5 percentage points.[25] In contrast to the previous literature, their estimates of the effect on investment are unusually low, at an increase between 0.5 and 1.5 percentage points.

Two model-based simulations estimated the impacts of the reform. Funke and Strulik (2003) predicted that the reform would increase the size of the capital stock by 5 to 14 percent and increase consumption by 0.65 to 2.2 percent.[26] In 2011, Masso and Meriküll simulated the reform and estimated that it would increase the capital stock by 10 percent, output by 4 percent, and consumption by 1 to 2 percent. Furthermore, they found that considering administration agency costs, the reform would also decrease the debt financing ratio by 6 percentage points and increase consumption by 3 to 4 percent.[27]

Immediately after the introduction of a DPT, corporate tax revenues fell from 2 percent to 1 percent of GDP, rebounding to 1.5 percent in the third year after the reform.[28] The revenue effects remained negative until 10 years after the reform.

Regarding the introduction of a DPT in Latvia, Jurša (2021) provides a cautionary note about combining the reform with corporate rate increases, indicating the anticipated corporate rate increase from 15 to 20 percent coupled with the reform led investors to increase dividend payments and reduce retained earnings prior to the reform to take advantage of the old lower rate.[29]

The Proposal

Under the proposed reform, all business entities would face the same statutory tax rate on distributed profits at the Polish corporate income tax rate of 19 percent. Special lower rates for patent income and small enterprises would be repealed.

The tax base would be greatly simplified. Under a DPT, profit is not calculated on an annual basis. As a result, there is no need to calculate depreciation deductions for capital assets each year. The DPT would also eliminate deductions for any forms of finance. Interest would no longer be deductible and the NID would be eliminated. Changing the timing of tax to distribution would also eliminate the need for net operating loss carryforwards or carrybacks.

We assume that this reform would maintain a policy to reduce the attractiveness of debt-financed investment consistent with the EU’s ATAD. Since interest would no longer be deductible, there would be no effect from limiting interest deductions. Instead, we assume that there would be an excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. on interest payments from highly leveraged firms equal to the statutory tax rate. We assume the same EBITDA-to-interest expense ratio as under current law of 30 percent. As such, interest expense would be taxable when distributed for any expense exceeding the EBITDA limitation.

Impact of Proposal on Investment Incentives

The DPT would improve investment incentives in three ways.

First, it would reduce the overall tax burden on investment in Poland. We estimate that the weighted average EMTR on all capital assets would fall from 8.1 percent to 3.3 percent. The modest reduction in the tax burden is due to the uneven effect across types of assets. Certain assets—such as plant and equipment, structures, inventory, and land—would see a reduction in their tax burden. In contrast, intellectual property would see a net tax increase.

Second, the DPT would equalize the tax burden across all types of assets. Regardless of the type of asset, the EMTR would be 3.3 percent. As a result, the standard deviation across all assets would fall to 0 percent. This is due to several changes to the tax base. First, differences arising due to capital allowances would be eliminated. Second, special provisions that benefit intellectual property, such as the super deduction and the patent box, would be repealed.

Finally, it would reduce the tax distortion across forms of financing. We estimate that debt-financed investment would face an EMTR of 3.4 percent while the EMTR on equity-financed investment would be 3.2 percent. Debt-financed investment would face a positive tax rate because the portion of interest paid by highly leveraged firms would face taxation. Furthermore, a tax differential would be introduced between forms of equity-financed investment. Since profits are ultimately taxed when distributed as dividends, new equity-financed investment would face taxation while investment financed by tax-free retained earnings would face no tax.[30]

Table 3. Effective Marginal Tax Rates for New Investment Under a Distributed Profits Tax in Poland

Source: Authors' calculations.

Macroeconomic Implications

The DPT’s impact on investment incentives would have broader implications for the Polish economy. Notably, a moderately increased incentive to invest and improved allocative efficiency across assets would increase the size of the Polish capital stock and result in higher labor productivity, wages, and economic output.

We estimate that permanent enactment of a DPT in Poland would increase output by 2.3 percent in the long run. Higher output would be driven by a 3.3 percent larger capital stock. The higher output would be associated with 2.0 percent higher wages.

Table 4.

In addition to higher economic output, enactment of the DPT would result in other macroeconomic improvements. As discussed above, the DPT would reduce the bias in favor of debt-financed investment. Previous research suggests that a reduction in the rate against which interest can be deducted (the effective subsidy for debt financing) is associated with a reduction in firm leverage.

The empirical literature finds a marginal tax effect of the corporate tax rate on the debt ratio of 0.27.[31] Applying this elasticity to the Polish tax treatment of debt, the adoption of a DPT implies a reduction of the tax differential between equity and debt that would lower the Polish economy’s debt financing share for private corporations by around four percentage points.

In comparison, the empirical literature on the introduction of a DPT in Estonia tends to find larger impacts, with Hazak (2009) and Masso and Meriküll (2011) estimating a decrease of 6.5 percentage points and Masso, Meriküll, and Vahter (2013) estimating a 9.5 percentage point decrease.

The Treatment of Losses and Risky Investments

An important benefit of enacting a DPT in Poland is an improvement to the tax treatment of risky investments and firms with variable profits and losses. As discussed above, the current Polish corporate income tax has relatively restrictive loss provisions. Corporations are only able to carry forward losses for up to five years and only half of a corporation’s total net operating losses can be deducted in a year. This treatment of losses can potentially punish risky investments. [32]

A risky investment is one that has the potential to lose money. For example, research and development in a novel drug may or may not prove fruitful. This contrasts with capital assets, such as machinery or equipment, which are more likely to produce predictable returns.

A corporate tax that allows for an immediate refund of losses does not place a tax burden on risk taking by corporations.[33]

The Polish tax code, which has very restrictive limitations of loss deductions, penalizes firms that make these investments. With the inability to fully deduct losses, corporations will either be required to merge with larger firms that have positive taxable income or forgo risky investments altogether due to their higher cost of capital.

Replacing the Polish corporate income tax with a DPT would reduce this penalty on risk taking. Since firms do not calculate taxable income each year, the timing of profits and losses are less of a concern for investments. For investments financed by retained earnings, the investment is tax-free, reducing the Polish tax system’s overall penalty on risk taking.

Distribution-based systems also avoid potential adverse incentives associated with more generous loss carrybacks.[34] In a traditional tax system, infinite loss carrybacks are hard to administer, because they could encourage gaming: firms overstating expenses to receive refunds from the government.

Revenue Implications

The introduction of a DPT would shrink the base of Poland’s corporate income tax. However, the reform’s ultimate impact on tax revenue depends on firm behavior—primarily the payout ratio of affected firms—and its impact on the broader economy.

Table 5. Revenue Implications of a Distributed Profits Tax in Poland

Note: Figures in billions of 2019 PLN.
Source: Authors’ calculations.

Our initial estimates indicate that the reform would cost the Polish government PLN 36.7 billion in static tax revenue, or 1.6 percent of GDP once fully phased in. In the long run, the positive macroeconomic impacts of the reform cut this figure by a third, to PLN 24.64 billion. The compensating effects can be mostly attributed to increases in sources of tax revenue other than corporate tax itself. Our calculation includes revenue from personal income taxes, social security contributions, and value-added taxes. Together, these four sources of tax revenue made up more than 80 percent of Poland’s tax revenue in 2019.[35] We assume that the personal income tax and social contribution schedules are kept at a constant proportion to the wage level.

Conclusion

The Polish government is considering converting its traditional corporate income tax into a tax on distributed profits. Such a tax, which has been adopted by countries such as Estonia, would reduce investment distortions for corporations. It would modestly reduce the overall tax burden on investment in Poland, eliminate distortions across types of assets, and significantly reduce the distortion across forms of financing. We estimate that this reform would result in greater investment, a larger productive capital stock, and higher economic output in the long run. This tax would also reduce the penalty that the current Polish corporate income tax places on risky investment.

Appendix

Methodology

The macroeconomic model used in this analysis is a comparative statics model of the Polish economy. The model makes four primary assumptions. First, that Poland is a small open economy. As such, the after-tax return on investment (before shareholder taxes) is fixed in the long run. Second, labor and capital share of gross output and each non-government sector’s share of output is constant in the long run. Third, the inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. rate is held constant. Fourth, tax changes are permanent, and government debt is sustainable in the long run.

The model utilizes a Cobb-Douglas production function with constant returns to scale. The model includes four sectors: general government, non-financial corporations, financial corporations, and households and institutions. Output in each sector, I, is formulated as:

Y = A K^a_i L^{(1- a_i)}

Where Y is total output (in zlotys), A is total factor productivity and is held constant, K is capital (measured in zlotys), and L is labor (measured in hours), and a and (1 – a) is a constant representing the output elasticity for capital and labor, respectively. The output elasticities for each sector are estimated at baseline and equal to:

a_i = SK / Y

(1 – a_i) = wL / Y

S is the observed service price in each sector. In the nonfinancial corporate sector, for example, the service price of capital is equal to the sum of profits, net interest, and the consumption of fixed capital for nonfinancial corporations divided by the nonfinancial corporate capital stock. K is the sum of plant and equipment, structures, intellectual property products, inventories, and land. w is the wage rate.

To simulate a change in the economy, the service price of capital is re-estimated based on changes in tax policy. The baseline service price of capital for each asset (a) and sector (i) follows the formulation by Hall and Jorgensen (1967)[36] and is equal to:

S_i,a = (r + δ – π)(1 – u z_a-k) / (1 – u)

Where is S is the service price of capital, r is the firm’s discount rate, π is the inflation rate, δ is economic depreciation, u is the statutory tax rate, z is the present discounted value of depreciation deductions for each specific asset (a), and k is the value of any investment tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income rather than the taxpayer’s tax bill directly. , net of any taxes paid on the credit.

The firm’s discount rate is the weighted average required return on debt- and equity-financed investment:

r = (E + π)(1 – f) + (i + π)(1 – u b) f

E is the real after-tax return on equity-financed investment, i is the real interest rate, π is the inflation rate, f is the share of investment financed by debt, u is the statutory tax rate, and b is the share of interest expense that is deductible against the statutory corporate income tax.

Under the proposed reform, there is no annual tax calculation. As such, the service price is equal to the firm’s nominal discount rate, r, plus economic depreciation, net of inflation.

S_i,a = r + δ – π

The value of r depends on the source of financing. For debt financing, the discount rate is equal to the nominal interest rate, i, grossed up by the tax on leverage equal to the tax on distributions t_d times the share of interest subject to tax, b.

r_debt = i / (1 – t_{d b})

Equity-financed investment can either come from retained earnings or new equity. Retained earnings are tax-free and the nominal discount rate is equal to the nominal after-tax return on equity:

r_{retained earnings} = E + π

The tax on distributions is capitalized into new equity. As such, the discount rate for this source of financing is:

r_{new equity} = (E + π) / (1 – t_d)

Table A1 outlines major economic and policy parameters used in the analysis. The model is based on national accounts data from Poland for 2019. This data allows us to calculate baseline shares of income and output by sector. We assume that the real interest rate is 5 percent and inflation is 2 percent. We assume that 35 percent of new investment is debt financed, 6.5 percent is financed with new equity, and 58.5 percent is financed with retained earnings.

Table A1. Overview of Major Parameters

Source: Authors’ calculations.

In estimating the weighted average service price, we weighted each type of capital by its share of the capital stock in Poland. Each of the 11 types of capital in each sector was matched with the appropriate cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. regime under current law. Intellectual property is split into two major categories: research and development, which qualifies for the super deduction, and acquired IP, which does not. We further assume that one-third of both types of IP qualifies for the patent box—the special 5 percent tax rate on qualifying IP income.

To capture the impact of allocative distortions in the corporate tax base, we use a weighting procedure that captures the dispersion of effective tax burdens on investment across types of assets and forms of financing. As such, the weighted value of the economy-side service price of capital, S, at baseline and simulation is equal to:

S = √(∑ w_i,f ρ_i,f²) + ∑ w_i,f δ_i,f

Where is each asset, is each form of financing, is the capital stock weight, is the pre-tax required return, and is economic depreciation. Figure A1 shows the contribution of the level effect of service price of capital vs. the allocative effect from the dispersion of the service price of capital due to the simulated reform.

Figure A1.

Finally, we used Polish national accounts data and our macroeconomic analysis to estimate the static and dynamic revenue effect of the proposed reform. In assessing the dynamic revenue effect, we assumed that the share of retained profits would rise by 7.5 percentage points in response to the lower tax rate in line with Pikakken and Vaino (2018).

The Tax Treatment of Risk Under Full Loss Refunds

Suppose a business can either invest €100 in a risk-free asset that produces a guaranteed return of 4 percent (€4) or a risky investment that has a 50 percent chance to either earn a 30 percent return (€30) or a 50 percent chance to lose 10 percent (-€10)—an expected return of 10 percent. The return on the risky asset can be broken down into two components: the risk-free return of 4 percent (€4) plus a risk premium of 6 percent (€6). The risk premium of 6 percent is the weighted sum of a 26 percent (€26) positive return and a negative 14 percent return (-€14).

Suppose the firm faces an income tax of 25 percent. This means the risk-free investment earns a 3 percent return after tax (€3). The risky investment will either earn 22.5 percent (€22.5) or will lose 7.5 percent (-€7.5) with an expected return of 7.5 percent (€7.5). Although this appears to tax risk by reducing the expected return, it does not because the firm can reverse this reduction in the returns to risk (the expected risk premium) by increasing its investment in the risky return by 33 percent.[37]

In the presence of a 25 percent income tax, the firm will instead invest €133 in a risky asset by borrowing €33 at the risk-free rate. In the following year, the firm expects to earn the risk-free return of 4 percent: €138.32. After paying back the loan of €33 plus interest (€34.32) and paying tax on the return, the firm expects to be left with €103—a €3 risk-free after-tax return. In addition, the firm expects a risk premium of 10 percent: 50 percent chance of earning 26 percent (€34.67) and a 50 percent chance of losing 14 percent (-€18.67). After tax, these values are exactly the same as they were without tax: €26 and -€14. On net, only the risk-free return is taxed.

This does not hold if the firm is unable to immediately deduct (or receive a refund for) its losses. For example, a firm may expect to lose 25 percent of its loss deductions in present value. In this case, increasing the stake in the asset by 33 percent would not reverse the tax on risk. The after-tax return is reduced, in expectation, to 5.4 percent. This is because in the case in which the risky investment does not pay off, the loss is not fully offset. The penalty is larger the more limited losses are for the firm.

References

[1] Asa Johansson et al., “Tax and Economic Growth,” OECD, Jul. 11, 2008, https://oecd.org/tax/tax-policy/41000592.pdf.

[2] Clemens Fuest, Andreas Peichl, and Sebastian Siegloch, “Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany,” American Economic Review, 2018, https://aeaweb.org/articles?id=10.1257/aer.20130570.

[3] Alex Durante, “Who Bears the Burden of Corporation Taxation? A Review of Recent Evidence,” Tax Foundation, Jun. 10, 2021, https://taxfoundation.org/blog/who-bears-burden-corporate-tax/.

[4] Alex Mengden, International Tax Competitiveness Index 2024, Tax Foundation, Oct. 21, 2024, https://taxfoundation.org/research/all/global/2024-international-tax-competitiveness-index/.

[5] Alex Mengden, “Capital Cost Recovery across the OECD, 2024,” Tax Foundation, https://taxfoundation.org/data/all/global/capital-allowances-cost-recovery-2024/.

[6] Wian Boonzaaier et al., “How do small firms respond to tax schedule discontinuities? Evidence from South African tax registers,” International Tax and Public Finance (2019), https://link.springer.com/article/10.1007/s10797-019-09550-z; Anne Brockmeyer, “The Investment Effect of Taxation: Evidence from a Corporate Tax Kink,” Fiscal Studies (2014), https://jstor.org/stable/24440325.

[7] Corporations that finance research and development with debt would face an increase in the cost of capital due to a less valuable interest deduction, which would provide $0.05 in tax savings per dollar of interest paid instead of $0.19 in tax savings per dollar of interest paid.

[8] Fabian Gaessler, Bronwyn H. Hall, and Dietmar Harhoff, “Should There Be Lower Taxes on Patent Income?,” NBER, June 2019, https://nber.org/papers/w24843.

[9] Giorgia Maffini, Jing Xing, and Michael P. Devereux, “The Impact of Investment Incentives: Evidence from UK Corporation Tax Returns,” American Economic Journal (2019); Eric Zwick and James Mahon, “Tax Policy and Heterogeneous Investment Behavior,” American Economic Review (2017), https://aeaweb.org/articles?id=10.1257/aer.20140855; Yongzheng Liu and Jie Mao, “How Do Tax Incentives Affect Investment and Productivity? Firm-Level Evidence from China,” American Economic Association (2019), https://aeaweb.org/articles?id=10.1257/pol.20170478.

[10] Alex Muresianu and Alex Durante, “Understanding the Tax Treatment of Inventory: The Role of LIFO,” Tax Foundation, Oct. 12, 2022, https://taxfoundation.org/research/all/federal/lifo-tax-treatment-inventory/.

[11] Deloitte, “EU Anti-Tax Avoidance Directive – Implementation of interest expense limitation rules,” March 2021, https://deloitte.com/content/dam/Deloitte/global/Documents/Tax/dttl-tax-eu-anti-tax-avoidance-directive-implementation-of-interest-expense-limitation-rule.pdf.

[12] Ibid.

[13]Ulve Tax & Legal, “Chance for additional tax costs – NID,” https://ulve.pl/en/chance-for-additional-tax-costs-nid/; PwC, “Worldwide Tax Summaries,” Jul. 22, 2024, https://taxsummaries.pwc.com/poland/corporate/deductions.

[14] PwC, “Worldwide Tax Summaries,” Jul. 22, 2024, https://taxsummaries.pwc.com/poland/corporate/deductions.

[15] Alex Mengden, “Net Operating Loss CarryforwardA Net Operating Loss (NOL) Carryforward allows businesses suffering losses in one year to deduct them from future years’ profits. Businesses thus are taxed on average profitability, making the tax code more neutral. In the U.S., a net operating loss can be carried forward indefinitely but are limited to 80 percent of taxable income. and Carryback Provisions in Europe, 2024,” Tax Foundation, May 2024, https://taxfoundation.org/data/all/eu/net-operating-loss-tax-europe-2024/.

[16] Daniel Bunn, “Poland Borrows an Idea from Estonia’s Tax System, but Misses the Point,” Tax Foundation, Dec. 2, 2020, https://taxfoundation.org/blog/poland-small-business-tax/.

[17] Rödl & Partner, “Changes to ‘Estonian’ CIT,” https://www.roedl.pl/en/services/tax-advisory/estonian-cit.

[18] Bloomberg Tax, “Country Guides,” https://go.bloombergtax.com/product/tax/page/page_international.

[19] Grant Thornton, “Purpurowy Informator Estoński CIT 2024,” October 2023, https://grantthornton.pl/wp-content/uploads/2022/12/Purple-Prospectus-Estonian-CIT.pdf.

[20] Republic of Poland, “Tax reliefs in Poland for research, development and innovation,” https://gov.pl/web/poland-businessharbour-en/tax-reliefs-in-poland-for-research-development-and-innovation.

[21] Lithuania’s corporate income tax system from 1997 to 2002 exempted reinvested but not all retained earnings from corporate income taxation.

[22] Aaro Hazak, “Companies’ Financial Decisions Under the Distributed Profit Taxation Regime in Estonia,”
Emerging Markets Finance and Trade, July 2009, https://doi.org/10.2753/REE1540-496X450401.

[23] Jaan Masso, Jaanika Meriküll, and Priit Vather, “Shift from gross profit taxation to distributed profit taxation: Are there effects on firms?,” Journal of Comparative Economics (November 2013), https://doi.org/10.1016/j.jce.2013.01.011.

[24] Ibid., Annex 1. The difference-in-difference estimation results of the effect of the corporate income tax reform over the longer sample, Estonia, Latvia and Lithuania, 1996-2008.

[25] Panu Pikkanen and Kaisa Vaino, ”Long-Term Effects of Distributed Profit Taxation on Firms: Evidence from Estonia,” Lund University, 2018, https://lup.lub.lu.se/luur/download.

[26] Michael Funke and Holger Strulik, “Taxation, growth and welfare: Dynamic effects of Estonia’s 2000 income tax act,” BOFIT Discussion Papers, No. 10 (2003), https://econstor.eu/bitstream/10419/212524/1/bofit-dp2003-010.pdf.

[27] Jaan Masso and Jaanika Meriküll, “Macroeconomic effects of zero corporate income tax on retained earnings,” Baltic Journal of Economics (2011), https://10.1080/1406099X.2011.10840502.

[28] OECD Data Explorer, “Comparative Tables of Revenue Statistics in OECD Member Countries,” Nov. 22, 2024, https://data-explorer.oecd.org/.

[29]Aleksejs Jurša, “Structural Analysis of Inward Foreign Direct Investment in Latvia,” Humanities and Social Sciences: Latvia 21:1 (2021), https://doi.org/10.22364/hssl.29.1.05.

[30] This stems from the fact that the Estonian cash flow tax is not a pure cash flow tax. Ideally, new equity would face no tax burden by providing a deduction for capital contributions. See Alexander D. Klemm, “Why and How to Tax Corporate Income,” in Corporate Income Taxes under Pressure, International Monetary Fund, 2021, https://imf.org/en/Publications/Books/Issues/2021/03/01/Corporate-Income-Taxes-under-Pressure-Why-Reform-Is-Needed-and-How-It-Could-Be-Designed-48604.

[31] Lars P. Feld, Jost H. Heckemeyer, and Michael Overesch, “Capital structure choice and company taxation: A meta-study,” Journal of Banking and Finance (2013), https://doi.org/10.1016/j.jbankfin.2013.03.017.

[32] Dominika Langenmayr and Rebecca Lester, “Taxation and Corporate Risk-Taking,” American Accounting Journal (2018), https://doi.org/10.2308/accr-51872.

[33] See example in the appendix.

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